General Equilibrium Pricing of Currency and Currency Options with Variable Disasters and Recursive Utility

This paper proposes a preference-based general equilibrium model that explains various pricing features of currency and currency options. The central ingredients are i) a variable disaster component that is highly but imperfectly shared across countries; and ii) the separation of EIS from risk aversion facilitated by the Epstein-Zin preference which enables the direct pricing of disaster risks. The predominant global disaster component reconcile the discrepancy between poorly shared consumption shocks and high risk sharing implied from the smooth exchange rate series. When investors prefer intertemporal risk to resolve sooner than later, shocks on home disaster intensity produce the negative correlation between the home interest rate and the premia demanded for holding foreign bonds, which explains why high interest paying currencies tend to appreciate. Country-specific disasters move independently, and they induce skewness in exchange rate changes with opposite signs, which generates the substantial variations in option risk reversal as a measure of the skewness. The model also accounts for the aggregate stock and option market behaviors